DERIVATIVES

As the word implies, a derivative instrument is derived from “something” backing it. This
something may be – A loan, an asset, an interest rate, a currency flow, a stock trade, a commodity
transaction etc.
Derivates enable a company to hedge a company to hedge “this some thing” without
changing the flow associated with the business operations.

Kinds of Financial Derivatives:

The Important financial derivatives are as follows;
1. Forwards
2. Futures
3. Options
4. Swaps.

FORWARDS
Forwards are the oldest of all derivatives. A forward contract refers to an agreement
between two parties to exchange an agreed quality of an asset for cash at a certain date in future
at a predetermined price specified in the agreement.

Features of Forward Contracts:

• Over the Counter Trading (OTC).
• No down Payment
• Settlement at Maturity.
• Linearity (Loss of a forward buyer is the gain of the forward seller)
• No Secondary Market
• Necessity of a third party
• Delivery.
Forward Rate contracts for commodities.
Forward Rate contracts for currency.
Forward Rate contracts for Interest Rates.

FUTURES
A future contract is very similar to a forward contract in all respects excepting the fact
that it is completely a standardized one. Hence, it is rightly said that a futures contract is nothing
but a standardized forward contract. It is legally enforceable and it is always traded on an
organized exchange.
Clark has defined future trading “as a special type of futures contracts bought and sold
under the rules of organized exchanges.”
A future contract is one where there is an agreement between tow parties to exchange any
asset or currency or commodity for cash at a certain future date, at an agreed price. Both the
parties to the contract must have mutual trust in each other. It takes place only in organized
future markets and according to well established standards.
Short Position: This commits the seller to deliver an item at the contracted price on
maturity.
 Long Position: This commits the buyer to purchase.
Key features of Futures contracts:
• Standardization.
• Intermediation by the Exchange.
• Price Limits.
• Margin requirements.
• Marking to market.

Standardization: It is standardized, so that it can be traded in the stock exchange.

Intermediation by the exchange:

Buyer of the Future Seller of the

contract Exchange contract

Price Limits:

Margin Requirements: (Initial Margin)

Marking to market: while the forward contracts are settled down the maturity date futures
contracts are ‘marked to market’ on a periodic basis. This means that profits and losses on future
contracts are settled on a periodic basis.

Types of Future Contracts – (The Global scene types of Futures)

1. Commodity Futures
2. Financial Futures.

Commodity Futures: A commodity futures is a future contract in commodities like agricultural

products, metals and mineral etc. Some of the will established commodity exchanges are as
follows.
• London Metal Exchange (LME) – to deal in gold.
• Chicago Board of Trade (CBT) – to deal in Soya bean oil.
• New York cotton Exchange – to deal in cotton.
• Commodity exchange in New York (COMEX) – to deal in agricultural products.
• International Petroleum Exchange of London (IPE) – to deal in crude oil.

Financial Futures: Financial futures refer to a futures contract in foreign exchange or financial
instruments like Treasury bill, commercial paper, stock market index or interest rate.
Some of the well established financial futures exchanges are the following;
1. International Monetary Market (IMM) to deal in US treasury bills, Euro dollar deposits
etc.
2. London International Financial futures exchange (LIFFE) to deal in Euro dollar deposits.
3. New York Futures Exchange (NYFE) to deal in Euro dollar deposits etc.

Types of Future Contracts – (In Indian Context)

Equity Futures in India:
Equity futures are of two types;
1. Stock index futures
2. Individual Securities.

[Refer Prasanna Chandra (SAPM), Page number – 469 & 470 (old). 541& 542 (new)]

Derivative Instruments in Equity Market:

Futures – Index Futures

Stock Futures

Options – Index Option

Stock Option

Participants in the Derivatives Market:

• Hedger: Reduces / eliminates his risk.
• Speculator: Bets on future movements in the price of an asset.
• Arbitrageur: Takes advantage of a discrepancy between prices in two different markets.

Index Futures:
• Index is the underlying security
• Derive their value from the underlying index
• Date of commencement of trading at NSE is 2/6/2000.

Stock futures:
• Stock is the underlying security.
• Derive their value from underlying stock.
• Date of commencement of trading is 9/11/2001

VALUATION OF FUTURES

I. Pricing future Contracts.

1. Cost & Carried model

Fo = So (1 + rf)t

2. When dividend are expected

Fo = So (1 + rf – d)t

So = Spot Price,
rf = Risk Free
t = time period.
OPTIONS
An option gives its owner the right to buy or sell an underlying asset on or before a given
date at a fixed price.

How options work?

A potion is a special contract under which the option owner enjoys the right to buy or sell
something without the obligation to do so.

Call Option: Right to Buy a specified underlying at a set price on/or before an expiration date.
Put Option: Right to Sell a specified underlying at a set price on/or before on expiration date.
Option Holder: The buyer of the option.
Option Writer: The seller of the option.
Exercise price or Striking price: The fixed price at which the option holder can buy and/or sell
the underlying asset.

Options can be exercised in two ways:

1. European Option.
2. American Option.
Depending on how the exercise price compares with the market price, options are said to be at
the money, in the money and out of the money as shown below.

Call Option Put Option

At the money EP = MP EP = MP
In the money EP< MP EP>MP
Out of the money EP>MP EP<MP

Options & their Pay-off just before expiration:

Call Option – Pay off of a Call Option:

The Pay off of the call option (C) just before the expiration depends on the relationship
between the stock price (S1) and the exercise price (E).

Formally, - C = S1 – E if S1 > E
C = 0 if S1 ≤ E

Pay off of a
Call option
P/L

E
Put Option – Pay off of a Put option:
The payoff of a put just before expiration depends on the relationship between the
exercise price (E) and the price of underlying security (So1).
If So1>E, the put option has a value of E-So1 and is said to be “in the money”

Pay off of put

option
p/loss

OPTION STRATEGIES: You can achieve an innumerable variety of pay off patterns by
combining puts and calls with various exercise prices. Some of the more popular strategies are
discussed below.

1. Protective Put: Suppose you are interested in investing in a stock because its upside
potential attracts you. How ever, you are concerned about fall in its price. To protect
yourself against potential losses beyond some given level, you can invest in the stock and
simultaneously purchase a put option on it. Such strategy is called Protective Put strategy.
2. Covered Call: A covered call strategy involves writing call option an asset along with
buying the asset. It is called a “covered position because the potential obligation to
deliver the stock is covered by the underlying stock in the portfolio.
3. Straddle: A long straddle involves buying a call as well as a put on a stock at the same
exercise price.
4. Spread: A spread involves combining two or more call options (or two or more Put
options) on the same stocks with differing exercise prices or times of maturity. Some
options are bought and some options are sold. A vertical or money spread involves
purchase and sale of options at different exercise prices. A horizontal or time spread
involves purchase and sale of options with differing expiration dates.

Key Factors Determines the option values:

1. Exercise Price.
2. Expiration Date.
3. Stock Price.
4. Stock Price Variability.
5. Interest Rate.
Black & Scholes Model:
Fisher Black & Myron Scholes published their famous model in 1973. The basic idea
underlying their model is to set up a portfolio which invites the call option in the pay off. The
cost of such portfolio, which is readily observed, must represent the value of call option.
Calculating the value of such a portfolio and through that the value of call option in such
a situation appears to be unwieldy task, but Black & Scholes developed a formula that does
precisely that. The formula is as follows.

Co = So N(d1) – E/ert N(d2)

Where,
Co = Equilibrium value of call option.
So = Price of the stock now
E = Exercise Price
e = Base of natural logarithm
r = Annualized continuously compounded risk – free interest rate.
t = Length of time in years to the expiration date.
N(d) = Value of cumulative normal density function.

ln (So/E) + (r + 1/2 σ2) t

d1 = ----------------------------
σ√t

d2 = d1 - σ√t

Where,
ln = Natural logarithm
σ = Standard deviation of the annualized continuously compounded of return on the stock.

ASSUMPTIONS
The assumptions underlying Black & Scholes model are as follows;
• The Call Option is a European Option.
• The Stock price continuous and is distributed log normally.
• There are no transaction costs and taxes.
• These are no restrictions and penalties for short selling
• The Stock pays no dividend
• The risk – free interest rate is known and constant.

Equity Option in India

 • Index Option
• Individual Securities.

[Refer Prasanna Chandra (SAPM), pages – 454 & 455 (old), 523 – 525 (new)]